Finance Week 9

Question 1

What is the rate of return on a stock?

Answer 1

When an investor buys a stock at initial price P0, the investor receives a dividend D1 and a capital gain or loss from price changes P1-P0. Rate of return of investment is therefore: Return = (Div 1 + (P1-P0)) / P0.

Question 2

What does a stock consist of?

Answer 2

A dividend yield and a capital gain or loss. Dividend yield: Div 1 / P0 Capital gain/loss: P1-P0/P0

Question 3

What is a stock market index?

Answer 3

Measures of the investment performance of all stocks in market.

Question 4

What is Standard & Poor’s composite index?

Answer 4

SP500, most important, tracks performance of portfolio that holds largest 500 publicly traded US corporations and holds these stocks in proportion to their market cap

Question 5

What is the dow jones industrial average?

Answer 5

Oldest index, tracks performance of portfolio that holds 1 share of each of largest publicly traded US corporations in the US. Measures performance of largest corporations

Question 6

What is the Russel 2000 index?

Answer 6

Tracks performance of portfolio that holds shares of each of the largest 2000 publicly traded US corporations in the US. It is a measure of the performance of the smaller US corporations

Question 7

What is the average return for investors in the stock market?

Answer 7

11.5% last century

Question 8

What is the standard deviation of returns per year?

Answer 8

19.6% - annual returns fluctuate a lot and are risky.

Question 9

Returns of individual stocks or returns of stock market riskier?

Answer 9

Stock market less risky due to diversification

Question 10

What is diversification?

Answer 10

Strategy where combine many stocks into 1 portfolio to reduce overall risk of portfolio. Diff price movements of stocks balance out.

Question 11

How do you find return and standard deviation of portfolio of stocks?

Answer 11

To find return of portfolio- have to stocks A and B- Ra is return of stock A and Rb is return of stock B. Return of portfolio is: Rp = (Wa * Ra) + (Wb * Rb) where Wa and Wb are proportion invested in stock A and B. Standard deviation on formula sheet. includes Pa,b which is the correlation between 2 stocks

Question 12

How can co-movement of stocks be measured?

Answer 12

Correlation P ranges from -1 to 1. If move by same amount in opposite directions then perfectly -vely correlated and p = 1

Question 13

If 2 stocks don’t move with each other what is the p value? What id move by same amount in same direction?

Answer 13

Uncorrelated, p=0. Perfectly correlated, p=1.

Question 14

When does diversification work best?

Answer 14

When negatively correlated as price movements in 1 stock balanced by price movements in opposite direction.

Question 15

How do stocks usually behave?

Answer 15

Usually positively correlated as when economy is doing good the prices of most stocks up. VV. Most correlations between 0.3 and 0.6- diversification works as still balanced by price movements.

Question 16

How many stocks do you need to be diversified?

Answer 16

20-30. There is market risk (cannot be diversified away from) and firm risk (can)

Question 17

What is market and firm specific risk?

Answer 17

Market risk cant be diversified away from as it is the risk that results from economy wide sources of risk that affect the overall stock market. Systematic risk. e.g. changes in interest rates, pollution, FOREX, energy costs, pandemic

Question 18

Firm specific risk?

Answer 18

Can be diversified- results from firm-specific sources that only affect the specific firm. Idiosyncratic risk- fire in production, death CEO, competition.

Question 19

Average return of US T bills, Corporate bonds and stocks?

Answer 19

average return per year of US T bills is 3.8%, US bonds is 5.3%, Corporate bonds is 6% and Stocks is 11.5%

Question 20

What is the relationship between market wide events and market portfolio?

Answer 20

Market wide events affect all companies and returns on all stocks, use return on market portfolio as a measure for market wide events. If return on market portfolio up- sum of all market wide events +ve, down- negative.

Question 21

What is the market risk of an individual stock?

Answer 21

Measured as the sensitivity of the stocks return with the returns of the market portfolio. E.g. Ford’s market risk large as returns sensitive to return of market portfolio- they sell more cars when economy is doing good.

Question 22

How do you get the beta of a stock?

Answer 22

When plotting a stocks return vs market return, results in scatter plot and slope of line of best fit tells us sensitivity of stocks returns vs overall market portfolio. Slope is a measure of stocks risk and is called the beta.

Question 23

What if a stocks Beta is >1 what if it is <1?

Answer 23

> 1 - high beta stock/ aggressive stock- has returns that react more strongly than market portfolio to market wide events. <1- low beta stock/ defensive stock, stock returns react less strongly to market wide events than market portfolio- less sensitive to economy. High beta stocks- people buy more when economy well, low beta- buy regardless

Question 24

What is the Beta defined as?

Answer 24

Beta also defined as the covariance of a stock’s return with return of market portfolio / variance of returns of market portfolio.

Question 25

Know how to find return on portfolio, how do you find beta of protfolio?

Answer 25

Bp= (Wa * Ba) + (Wb * Bb) Ba and Bb are betas of those stocks

Question 26

What is the CAPM?

Answer 26

Says that the expected return on any asset is the return on the risk-free asset plus the beta of the asset multiplied by the market risk premium. Return = Return (rf) + B ( Return market - return risk free). It says you get compensation with risk free rate for waiting (TMW) and beta * risk premium for bearing beta amount of market risk.

Question 27

What do you do if asked the value of a stock using CAPM?

Answer 27

Use CAPM to find the return and use this as the interest rate in the valuation calculation.

Question 28

What is the average market risk premium over the last century?

Answer 28

7%, rf 3%

Question 29

What is the beta of the market portfolio?

Answer 29

Market portfolio has beta of 1 because it covaries one-to-one with itself